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United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Period Ended September 30, 2004

or

¨ Transition Report Pursuant to Section 10 or 15(d) of the Securities Exchange Act of 1934

For The Transition Period from                      to                     

Commission File Number 0-15449

CALIFORNIA MICRO DEVICES

CORPORATION

(Exact name of registrant as specified in its charter)

(408) 263-3214

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address, and former fiscal year if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No   ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Applicable Only to Corporate Issuers

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

The number of shares of the registrant’s Common Stock outstanding as of October 29, 2004 was 21,459,286.

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California Micro Devices Corporation

Form 10-Q for the Quarter ended September 30,2004

INDEX

PART I. FINANCIAL INFORMATION

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

California Micro Devices Corporation

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See Notes to Financial Statements.

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California Micro Devices Corporation

CONDENSED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

See Notes to Financial Statements.

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California Micro Devices Corporation

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See Notes to Financial Statements.

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California Micro Devices Corporation

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, the accompanying unaudited condensed financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of California Micro Devices Corporation (the “Company”, “we”, “us” or “our”) as of September 30, 2004, results of operations for the three and six month periods ended September 30, 2004 and 2003, and cash flows for the six month periods ended September 30, 2004 and 2003. Results for the three and six month periods are not necessarily indicative of fiscal year results.

The condensed balance sheet at March 31, 2004 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. The condensed financial statements should be read in conjunction with the financial statements included with our annual report on Form 10-K for the fiscal year ended March 31, 2004.

2. Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates are based on historical experience, input from sources outside of the Company, and other relevant facts and circumstances. Actual results could differ from these estimates, and such differences could be material.

3. Stock Based Compensation

As allowed under Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock Based Compensation,” we account for our employee stock plans in accordance with the provisions of Accounting Principles Board’s Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and have adopted the disclosure only provisions of SFAS 123. Stock based awards to non-employees are accounted for in accordance with SFAS 123 and EITF 96-18 “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” Fair value for these awards is calculated using the Black-Scholes option pricing model, which requires that we estimate the volatility of our stock, an appropriate risk-free interest rate, estimated time until exercise of the option, and our dividend yield. The Black-Scholes model was developed for use in estimating the fair value of traded options that do not have specific vesting schedules and are ordinarily transferable. The calculation of fair value is highly sensitive to the expected life of the stock based award and the volatility of our stock, both of which we estimate based primarily on historical experience. As a result, the pro forma disclosures are not necessarily indicative of pro forma effects on reported financial results for future years.

We generally recognize no compensation expense with respect to employee stock grants. Had we recognized compensation for the grant date fair value of employee stock grants in accordance with SFAS 123, our net income and net income per share would have been revised to the pro forma amounts shown below. For pro forma purposes, the estimated fair value of our stock based grants is amortized over the options’ vesting period for stock options granted under our stock option plans, and the purchase period for stock purchases under our stock purchase plan.

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The fair value of our stock based grants was estimated assuming no expected dividends and the following weighted average assumptions:

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4. Net Income (Loss) Per Share

The following table sets forth the computation of basic and diluted income (loss) per share:

Options to purchase 756,027 and 461,321 shares of common stock were outstanding during the three and six month periods ended September 30, 2004, respectively, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the average closing share trading price reported by Nasdaq (“Average Trading Price”) of the common shares during the three and six month periods ended September 30, 2004. For the three and six months ended September 30, 2004, all outstanding warrants were included in the computation of diluted earnings per share, because the exercise prices of the warrants were less than the Average Trading Price of the common shares during the periods.

Options to purchase 2,218,895 and 3,411,985 shares of common stock were outstanding during the three- and six- month periods ended September 30, 2003, respectively, but were not included in the computation of diluted earnings per share because the exercise price of the stock options was greater than the Average Trading Price of the common shares during the three month period ended September 30, 2003, and because we had a loss for the six month period ended September 30, 2003, and, therefore, the effect would have been anti-dilutive. Warrants to purchase 483,667 and 1,290,266 shares of common stock outstanding during the three and six month periods ended September 30, 2003, were not included in the diluted earnings per share computation, because the exercise price of the warrants was greater than the Average Trading Price of the common shares during the three month period ended September 30, 2003 and because we had a loss for the six month period ended September 30, 2003 and, therefore, the effect would have been anti-dilutive.

5. Inventories

The components of inventory consist of the following (amounts in thousands):

Inventory balances by stage at March 31, 2004 have been reclassified from amounts shown in our 10-K for the year ended March 31, 2004, to apportion inventory reserves in the same manner as presented for September 30, 2004.

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6. Litigation

We are a party to lawsuits, claims, investigations and proceedings, including commercial and employment matters, which are being handled and defended in the ordinary course of business. We review the current status of any pending or threatened proceedings with our outside counsel on a regular basis and, considering all the other known relevant facts and circumstances, recognize any loss that we consider probable and estimable as of the balance sheet date. For these purposes, we consider settlement offers we may make to be indicative of such a loss under certain circumstances.

During the three month period ended June 30, 2004 we settled pending cases with former employees Chan Desaigoudar and Tarsaim L. Batra. The settlements did not affect our results for the three or six month periods ended September 30, 2004, as our settlement costs had previously been accrued.

7. Comprehensive Income (Loss)

Comprehensive income (loss) is principally comprised of net income (loss) and unrealized gains or losses on our available for sale securities. We reported an unrealized loss of $1,000 on available for sale securities during the three months ended June 30, 2004, and as a result our comprehensive income for the three and six month periods ended September 30, 2004 was $2,183,000 and $4,140,000, respectively. Comprehensive income for the three month period ended September 30, 2003 was $682,000 and equaled net income, and comprehensive loss for the six month period ended September 30, 2003 was $538,000 and equaled net loss.

8. Income Taxes

For the three and six month periods ended September 30, 2004 we recorded income tax provisions of $67,000 and $128,000, respectively, for federal and state income taxes. Our effective tax rate benefited from our ability to utilize loss carry forwards and other credits; however, the benefit was limited by alternative minimum tax provisions. For the three and six month periods ended September 30, 2003, there was no income tax provision due to a net loss for the six month period.

9. Long-term Debt

In June 2002, we entered into a Loan and Security Agreement (“Agreement”) with Silicon Valley Bank that allowed us to borrow up to a total of $5.0 million under an equipment line of credit and a revolving line of credit. The amount available under the Agreement was based on the amount of eligible equipment and accounts receivable. Borrowings under the equipment line and the revolving line bear interest at an annual rate of prime plus 3.0% and prime plus 0.75%, respectively. As of March 31, 2004, the equipment line of credit rate was 7.25%. Principal, in equal installments, and interest were due monthly for the term of 36 months for all borrowings made under the equipment line. Borrowings under the revolving credit line had a term of 12 months, with principal due at maturity and interest due in monthly installments. On May 4, 2004, we used $6.6 million of the $18.0 million net proceeds from our May 3, 2004 public offering to repay our debt with Silicon Valley Bank. In the first quarter of fiscal 2005 we took a charge of $123,000 associated with the debt repayment. As of September 30, 2004 there was no balance outstanding.

On September 30, 2004, we entered into an amended and restated loan and security agreement with Silicon Valley Bank. Under this one year agreement, the bank will provide a $15 million credit line, which is subject to financial and other covenants contained in the agreement. We granted the bank a security interest in all of our assets other than our intellectual property. Borrowings under the Agreement bear interest at an annual rate equal to the prime rate; the interest rate increases or decreases when the prime rate changes. The agreement includes a loan fee of $50,000 plus bank expenses to execute the agreement. Accrued interest is payable monthly. The agreement expires on September 28, 2005, at which time any amounts borrowed must be paid in full. The bank may withdraw the commitment if we fail to comply with the covenants, if there is a material adverse change in our business, operations or condition, if we become insolvent or if other specified events or conditions occur.

In March 2001, we entered into an equipment financing agreement with Epic Funding Corporation which allowed us to finance $975,000 of equipment over a term of 4 years with interest at 9.6% payable in 48 installments of approximately $25,000 per month. The total outstanding obligation as of September 30, 2004 was approximately $143,000.

During fiscal 2003, we entered into capital leases to finance some equipment.

In September 2004 we entered into a three year software lease with Synopsys. We accounted for the agreement as a capital lease. Under the agreement, we will make three annual payments of $104,000, with the first payment due in October 2004. The amount capitalized is $246,000.

As of September 30, 2004, total capital lease obligations were $201,000, due in monthly or annual installments with interest rates ranging from 5% to 12.6%.

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Total fixed assets purchased under capital leases and the associated accumulated depreciation were as follows (amounts in thousands):

10. Short-term Investments

We invest our excess cash in high quality financial instruments. We have classified our marketable securities as available for sale securities. Our available for sale securities have contractual maturities of 90 days or less and are carried at fair value, with unrealized gains and losses reported in a separate component of shareholders’ equity. Realized gains and losses and declines in value judged to be other than temporary, if any, on available for sale securities are included in interest income. Interest on securities classified as available for sale is also included in Other Expense, Net. The cost of securities sold is based on the specific identification method.

Short-term investments were as follows (in thousands):

During the three and six month periods ended September 30, 2004, net unrealized holding losses of $0 and $1,000, respectively, were included in accumulated other comprehensive income. There were no gains or losses reclassified out of accumulated other comprehensive income (loss) into earnings for the period. During the three and six month periods ended September 30, 2003, we did not have any short-term investments and so there were no unrealized holding gains or losses for those periods.

11. Recent Accounting Pronouncements

At its November 2003 meeting, the Emerging Issues Task Force (“EITF”) reached a consensus on disclosure guidance previously discussed under EITF 03-01, “The Meaning of Other Than Temporary Impairment and Its Application to Certain Investments.” The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. We adopted the disclosure requirements during the fiscal year ended March 31, 2004. At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other than temporary impairment and its application to investments classified as either available for sale or held to maturity under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other than temporary impairment evaluations in reporting periods beginning after June 15, 2004. We do not believe that this consensus on the recognition and measurement guidance will have an impact on our results of operations.

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12. Major Customers

Major customers were as follows:

13. Stock Issuances

On May 3, 2004, we closed our public offering of 1,300,000 shares of common stock at a price of $15.00 per share with net proceeds of $18.0 million, after deducting the underwriting discount of $1.1 million and offering expenses of $368,000. We also granted the underwriters the right to purchase up to an additional 195,000 shares of common stock to cover over allotments, if any, at any time on or before May 26, 2004. The over-allotment right was not exercised and expired on May 26, 2004.

On May 24, 2004 and June 7, 2004, some of the investors in prior private placements and one of our placement agents exercised some of the warrants they had been granted in such private placements or had purchased from investors in such private placements. In total, such investors and placement agent exercised 36,663 warrants at an exercise price of $3.00 per share resulting in total proceeds of approximately $110,000 and exercised 225,179 warrants with an exercise price of $4.36 per share resulting in total proceeds of approximately $982,000, respectively. These warrant exercises were effected without registration under the Federal Securities Act of 1933, as amended, in reliance upon the exemption provided by Section 4(2) of such Act and Rule 506 promulgated under such Section as the holders were accredited institutional investors.

Also during the three and six month periods ended September 30, 2004, we issued the following shares of common stock under our employee stock option and employee stock purchase plans:

14. Infrastructure Alignment Plan

On September 29, 2003, the Board of Directors approved a plan to align our internal manufacturing operations to current business requirements. The plan provided for the termination of 61 employees for which severance costs of approximately $343,000 were recorded. During the three month period ended June 30, 2004, we terminated three employees who were included in the plan, which resulted in charges of $27,000 against the original $343,000 provision. We also reversed $68,000 of previously accrued charges for employees we chose to retain. At June 30, 2004, the remaining accrued employee severance liability was $13,000. During the three month period ended September 30, 2004 we reversed this remaining liability, as we decided to retain the remaining employees we had originally planned to terminate.

15. Contingencies

Environmental

During fiscal 2003, we closed our Milpitas wafer fabrication facility. As part of the closure process, we retained a state licensed environmental contractor familiar with this type of semiconductor manufacturing facility to prepare and implement a site closure plan and a site health and safety plan (HASP) to remove, decontaminate as necessary, and dispose of equipment and materials using approved methods and to work with the appropriate agencies to obtain certifications of closure. Upon inspection of the facility by the County of Santa Clara, one of four soil samples obtained by drilling through the floor in one room detected an elevated level of nickel. The County referred the matter to the California Department of Toxic Substances Control (“DTSC”), which in a June 23, 2003, letter requested that the Company conduct further soil and ground water investigation to assess the nature and extent of the contamination at the site from nickel and other substances. We entered into an agreement with the DTSC on February 26, 2004, and submitted a Preliminary Endangerment Assessment (“PEA”) work plan, which the DTSC approved on August 18,

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2004. Further testing identified an elevated level of chromium, in addition to nickel, on one area of the site. We have proposed a limited soil removal action in that area, which the DTSC is reviewing. The estimated cost of our proposed actions is approximately $50,000. Based on analytical data collected at the site to date, we do not anticipate that any further remediation at the site will be required. However, if the contamination is found to extend beyond the area currently delineated, additional actions may need to be taken. The cost of any such additional activities would ultimately depend on the nature and extent of contamination, if any, that is found beyond that expected and any risks posed by such contamination. In addition, our Tempe, Arizona facility is located in an area of known groundwater contamination.

16. Subsequent Events

In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter due to reduced customer demand for these products and to close our thin film manufacturing operation in Tempe, Arizona. As a result, we expect to incur $2.2 million to $3.2 million of costs related to terminating employees, selling or abandoning equipment and maintaining the Tempe facility until we sell it. We expect that approximately 60% to 70% of the costs will be charged to our results of operations during the three month period ended December 31, 2004.

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

In this discussion, “CMD,” “we,” “us” and “our” refer to California Micro Devices Corporation. All trademarks appearing in this discussion are the property of their respective owners. This discussion should be read in conjunction with the other financial information and financial statements and related notes contained elsewhere in this report.

Forward Looking Statements

This discussion and report contain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward looking statements are not historical facts and are based on current expectations, estimates, and projections about our industry; our beliefs and assumptions; and our goals and objectives. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” and “estimates,” and variations of these words and similar expressions are intended to identify forward looking statements. Examples of the kinds of forward looking statements in this report include statements regarding the following: (1) our expectation as to future levels of gross margin; (2) our expectation that we will have substantially lower sales of end of life products; (3) our expectation as to future levels of research and development expenses and selling, general and administrative expenses; (4) our expectations about our fiscal 2005 income tax rate and days sales outstanding; (5) our planned closure of our Tempe facility and its financial statement and cash flow implications; (6) our estimated costs to remediate environmental issues at our former facility on Topaz Avenue in Milpitas, California; and (7) our anticipation that our existing cash, cash equivalents and short term investments will be sufficient to meet our anticipated cash needs over the next 12 months after considering the anticipated costs of closing our thin film manufacturing operations in Tempe, Arizona. These statements are only predictions, are not guarantees of future performance, and are subject to risks, uncertainties, and other factors, some of which are beyond our control, are difficult to predict, and could cause actual results to differ materially from those expressed or forecasted in the forward looking statements. These risks and uncertainties include, but are not limited to, our expectation that customers will not change their minds and order end of life products remaining in our inventory but which we have already written off; whether we will decide to invest more or less in research and development or sales and marketing due to market conditions, technology discoveries, or other circumstances; whether we will incur unexpected expenses related to our internal controls as a result of our Sarbanes-Oxley Section 404 audit; whether our product mix changes, our unit volume decreases materially, we experience price erosion due to competitive pressures, or our contract manufacturers and assemblers raise their prices to us or we experience lower yields from them; whether there will be any changes in tax accounting rules; whether we receive any unexpected orders for our Medical products, whether we are able to realize what we expect for the Tempe property and equipment, and whether we encounter any unexpected environmental clean-up issues with our Tempe facility; whether we discover any further contamination at our Topaz Avenue Milpitas facility or delays which affect our former landlord’s pending sale of the building; and whether we will have large unanticipated cash requirements, as well as other risk factors detailed in this report, especially under the caption “Risk Factors and Other Factors That Could Affect Future Results” at the end of this discussion in this under Item 2. Except as required by law, we undertake no obligation to update any forward looking statement, whether as a result of new information, future events, or otherwise.

Overview

We design and sell application specific analog semiconductor products primarily for high volume applications in the Mobile, Computing and Digital Consumer markets. We are a leading supplier of application specific integrated passive (ASIP™) devices that provide electromagnetic interference filtering, electrostatic discharge protection and termination for high speed signals. We also offer a growing portfolio of active analog devices including power management and interface devices. Our ASIP devices, built using our proprietary silicon process technology, provide the function of multiple passive components in a single chip solution for densely populated, high performance electronic systems. Our ASIP devices are significantly smaller, offer increased performance and reliability, and cost our customers less, taking into account all of the costs of implementation, than traditional solutions based on discrete passive components. Some of our ASIP devices also integrate active analog elements to provide additional functionality. With our active analog device portfolio, we seek opportunities to design standard products that are differentiated from competitive alternatives by being optimized for specific applications. We also selectively design second source active analog devices that provide us entry to new applications, complement other products in our portfolio or enhance existing customer relationships. Our active analog device solutions use industry standard CMOS manufacturing processes for cost effectiveness.

During the past three years, we have streamlined our operations and become fabless for the semiconductor products that we supply to our customers in our core markets, using independent providers of wafer fabrication services. This decision to use independent foundries led us to close our fabrication facility in Milpitas, California and consolidate our thin film manufacturing activities in Tempe, Arizona. In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter due to lower customer demand for these products and to close our Tempe facility where we make them. The closure of our Tempe facility will complete the elimination of all of our internal manufacturing operations. See Note 16 of Notes to Financial Statements.

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During the past several years, we have also focused our marketing and sales on strategic customers in our three core markets. As a part of this process, we have reduced the number of our actively marketed products from approximately 5,000 to approximately 200 while at the same time increasing our unit shipments from less than 25 million in the quarter ended March 31, 2001 to approximately 101 million in the quarter ended September 30, 2004.

End customers for our semiconductor products are original equipment manufacturers including Dell, Hewlett-Packard, Kyocera Wireless, LG Electronics, Motorola, Samsung and Sony. We sell to some of these end customers through original design manufacturers, including Appeal, Arima, BenQ, Compal, Pantech and Quanta, and contract electronics manufacturers, including Celestica, Foxconn and Solectron. We use a direct sales force, manufacturers’ representatives and a network of distributors to sell our semiconductor products.

We operate in one operating segment and most of our assets are located in the United States. Our assets located outside the United States are comprised primarily of inventory or equipment used in manufacturing our products.

Results of Operations

Net sales. Net sales for the three month period ended September 30, 2004 were $17.1 million, a 15% increase from the three month period ended September 30, 2003. Net sales for the six month period ended September 30, 2004 were $33.5 million, a 25% increase from the six month period ended September 30, 2003. As shown in the table below, our Mobile products represented the largest component of these increases.

Our growth in Mobile sales is primarily due to our focus on increasing our penetration of the Mobile phone handset market. In addition to top tier manufacturers, we also sell our products to a large number of other handset manufacturers.

Computing and Digital Consumer sales were lower due to a decline in sales of our older products, price erosion in our Computing products and slowing growth in the Computing market.

In our Medical business, the decline in revenue for the three month period is the result of lower orders from our primary Medical products customer, Guidant Corporation. For the six month period, the increase is primarily the result of improved pricing from Guidant starting in July, 2003. In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter and close our Tempe thin film manufacturing operation. See Note 16 of Notes to Financial Statements.

Our sales from Other products declined during the three and six month periods ended September 30, 2004 compared to 2003, due to a decline in end of life sales for our legacy, lighting and communications products. For the three month period ended September 30, 2004 there was a substantial increase in sales of Other products compared to the three month period ended June 30, 2004 as a result of additional one time demand from two customers for certain end of life products. We completed shipment of most end of life product orders during fiscal 2004 and expect to recognize substantially lower sales of these products starting in the third quarter of fiscal 2005.

Units shipped during the three and six month periods ended September 30, 2004 increased to approximately 101 million and 209 million units, up from approximately 72 million and 127 million units for the three and six month periods ended September 30, 2003. For the three month period ended September 30, 2004, units shipped declined by 7% from the 108 million units shipped during the three month period ended June 30, 2004, primarily due to lower shipments to our distributors.

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Our increased net sales resulted primarily from larger unit sales, due in part from increased sales of current products and in part from sales of newly introduced products, and to a lesser extent, from price increases effective July 1, 2003, on our Medical products.

Our average unit price decreased by approximately 21% during the three month period ended September 30, 2004 compared to the three month period ended September 30, 2003. This decrease was primarily the result of a change in product mix, with our core product unit volumes increasing and our Medical and Other products decreasing in proportion to total units shipped.

Major customers were as follows:

Cost of Sales, Gross Margin and Expenses

The table below shows our net sales, cost of sales, gross margin and operating expenses, both in dollars and as a percentage of net sales, for the three and six month periods ended September 30, 2004 and 2003 (in thousands):

Cost of Sales. During fiscal 2004, we completed implementing a strategy to satisfy the production requirements for products in our core markets from external foundries, which we had previously manufactured in our own factories. As a result of outsourcing wafer fabrication, we converted our Tempe manufacturing operations to a dedicated thin film facility and reduced our manufacturing costs at that facility. During the three month period ended June 30, 2004 we took action to further reduce spending at our Tempe facility in anticipation of lower Medical product sales in future quarters. In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter and close our Tempe thin film manufacturing operation. See Note 16 of Notes to Financial Statements. Our thin film products are primarily Medical products plus a relatively small portion of our mature products, which are shown in the “Other products” category in the net sales discussion.

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Cost of sales increased by approximately $300,000 for the three month period ended September 30, 2004 compared to the three month period ended September 30, 2003 primarily due to the following reasons:

Cost of sales increased by approximately $1.0 million for the six month period ended September 30, 2004 compared to the six month period ended September 30, 2003 primarily due to the following reasons:

For the three and six month periods ended September 30, 2004, increases in net sales compared to the prior year periods directly resulted in increases in costs of $0.9 million and $2.9 million. The decreases in manufacturing spending were primarily due to the realignment of and reduction in spending at our Tempe wafer fabrication facility. The increases in cost of sales due to change in product mix were due to increased sales of our Mobile products as proportions of our total net sales.

We have, during recent quarters, benefited from the sale of previously reserved inventory due primarily to the large number of products for which we have discontinued future support by placing them in an ‘end of life’ category. These products have been primarily sold through our distributors to an erratic and unpredictable demand by end customers. As a result, we have experienced the actual sale of some products previously reserved and the requirement to further write down certain other products for which we had expected to receive orders but did not. The benefits related to sales of previously reserved inventory for the three month periods ended September 30, 2004 and 2003 were approximately $200,000 and $500,000, respectively, and for the six month periods ended September 30, 2004 and 2003 were approximately $400,000 and $800,000, respectively.

Gross Margin. Gross margin is comprised of net sales less cost of sales. For the three month period ended September 30, 2004, gross margin was $6.8 million, an increase of $1.9 million from the prior year period’s $4.9 million. For the six month period ended September 30, 2004, gross margin was $13.4 million, an increase of $5.7 million from the prior year period’s $7.6 million. Gross margin as a percentage of revenues was 40% and 33% for the three month periods ended September 30, 2004 and 2003, respectively, and 40% and 28% for the six month periods ended September 30, 2004 and 2003, respectively. The gross margin dollar increase during the three month period ended September 30, 2004 compared to the prior year was primarily the result of increased sales volumes and reductions in manufacturing spending. The gross margin dollar increase during the six month period ended September 30, 2004 compared to the prior year was primarily the result of increased sales volumes, a significant price increase for our Medical products and reductions in manufacturing spending. The gross margin percentage increases were primarily the result of increased sales volumes that led to economies of scale in our manufacturing operations, a significant price increase for our Medical products in the second quarter of fiscal 2004 which improved gross margins on these products to approximately the company target, and reductions in manufacturing spending. Gross margins during fiscal 2004 and to a lesser extent fiscal 2005 benefited from sales of our Other products, a portion of which were previously reserved and as a result generated a 100% gross margin. In future periods, we expect our gross margin to be approximately 40% of net sales on average, subject to substantial quarterly variation due to changes in volume, pricing, product mix, manufacturing costs and manufacturing yields.

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Research and Development. Research and development expenses consist primarily of compensation and related costs for employees and prototypes, masks and other expenses for the development of new products, process technology and new packages. The increases in research and development expenses for the three and six month periods ended September 30, 2004 compared to the same period in 2003 were due to the following:

In the future we expect to incur increased research and development expenses and to represent 8% to 9% of sales. However, if our sales were to decline in future periods, research and development could represent more than 9% of sales.

Selling, General and Administrative. Selling, general and administrative expenses consist primarily of compensation and related costs for employees, sales commissions, marketing and promotional expenses, and legal and other professional fees. The increases in selling, general, and administrative expenses for the three and six month periods ended September 30, 2004 compared to the same period in 2003 were due to the following:

The percentage of net sales comprised by selling, general and administrative expenses decreased during the same periods due to our increased net sales. These expenses are expected to increase in dollar terms in the future, but at a slower rate than our anticipated sales growth. As a result, we expect a gradual reduction in selling, general and administrative expenses as a percentage of sales; however, if our sales were to decline in future periods, these expenses could increase as a percentage of sales.

Income Taxes. For the three and six month periods ended September 30, 2004 we recorded income tax provisions of $67,000 and $128,000 for federal and state income taxes. Our effective tax rate benefited from our ability to utilize loss carry forwards and other credits; however, the benefit was limited by alternative minimum tax provisions. For fiscal 2005 we currently expect our effective income tax rate to be 3% of profit before taxes. For the three and six month periods ended September 30, 2003 there were no income tax provisions due to a net loss for the six month period.

Net Income. For the reasons explained above, we realized a net income of approximately $2.2 million and $682,000 for the three month periods ended September 30, 2004 and 2003, respectively, and a net income of $4.1 million and a net loss of $538,000 for the six month periods ended September 30, 2004 and 2003, respectively.

Recent Accounting Pronouncements

At its November 2003 meeting, the Emerging Issues Task Force (“EITF”) reached a consensus on disclosure guidance previously discussed under EITF 03-01, “The Meaning of Other Than Temporary Impairment and Its Application to Certain Investments.” The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. We adopted the disclosure requirements during the fiscal year ended March 31, 2004. At its March 2004 meeting, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF 03-01. The consensus clarifies the meaning of other than temporary impairment and its

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application to investments classified as either available for sale or held to maturity under FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and investments accounted for under the cost method or the equity method. The recognition and measurement guidance for which the consensus was reached in the March 2004 meeting is to be applied to other than temporary impairment evaluations in reporting periods beginning after June 15, 2004. We do not believe that this consensus on the recognition and measurement guidance will have an impact on our results of operations.

Critical Accounting Policies and Estimates

We described our critical accounting policies and estimates in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of our Annual Report on Form 10-K for the year ended March 31, 2004. Our critical accounting policies and estimates are related to financial line items that are key indicators of our financial performance or that require significant management judgment. Our critical accounting policies, which have not changed materially since March 31, 2004, include those regarding (1) revenue recognition; (2) inventory and related reserves; (3) impairment of long lived assets; (4) litigation, including environmental issues; and (5) income taxes. The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. We believe that we have consistently applied judgments and estimates that fairly depict our financial condition and results of operations for all periods presented. Below, we discuss further the critical estimates we make.

With respect to revenue recognition, we make estimates in relation to sales returns and allowances and to bad debt. To estimate sales returns and allowances, we analyze recent sales returns trends and open return material authorizations to evaluate the likelihood of future returns. Also, we consult with our sales, marketing and quality management personnel to identify any specific issues that may require a sales returns and allowances reserve provision. To estimate bad debt, we analyze our current aged accounts receivable to evaluate the likelihood of our not being able to collect payment from customers whose payments are overdue. Our policy is to partially or fully reserve receivables that are 90 days old or more, while at the same time continuing efforts to collect payment from the customer. We also maintain a general bad debt reserve to provide for collection risks involving customers with whom we do less business and as a consequence have less experience in evaluating their credit risk.

With respect to inventory and related reserves, the primary area of estimation and judgement is in the evaluation of products that we may have produced in excess of expected demand. Each period, we review current demand expectations in comparison to our inventory quantities for each product. In cases where the inventory quantity exceeds expected demand for the next 12 months for a product, we establish financial reserves against the excess inventory quantity. If demand occurs at a future date for inventory that has been reserved, we release the reserve during the period when revenue is recognized.

With respect to the impairment of long lived assets, we evaluate two separate measures of fair value to assess whether the carrying value of our equipment is appropriate. First, we forecast future cash flows to determine whether we believe that our future cash flows will be sufficient to recover the carrying value of those assets. Second, in cases where we have identified surplus assets that we have removed from service and are making available for sale, we estimate the net proceeds that we expect to realize upon sale. If expected net proceeds are less than the current net book value for a particular asset, we write down the value of the asset to the expected net sales proceeds. If we have strong evidence that we will be unable to sell the asset, we fully write off the value of the asset and take a charge in the period during which we have performed the assessment.

With respect to litigation, the potential exposure for legal disputes is very uncertain. We are a party to lawsuits, claims, investigations and proceedings, including commercial and employment matters, which are being handled and defended in the ordinary course of business. We review the current status of any pending or threatened proceedings with our outside counsel on a regular basis and, considering all the other known relevant facts and circumstances, recognize any loss that we consider probable and estimable as of the balance sheet date. For these purposes, we consider settlement offers we may make to be indicative of such a loss under certain circumstances.

With respect to environmental issues, we have a financial exposure related to our former site in Milpitas, California. The State of California’s Department of Toxic Substances Control is currently considering our proposed plan to remediate the site, for which the estimated cost of our proposed remediation is approximately $50,000; however, the cost will ultimately depend on the nature and extent of contamination that is found during the cleanup and any risks posed by such contamination. See Note 15 of Notes to Financial Statements.

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With respect to income taxes, we have provided a valuation allowance against our total deferred tax assets due to the uncertainties surrounding our ability to generate sufficient taxable income in future periods to realize the tax benefits of our loss carry forwards. See Note 11 of Notes to Financial Statements in our annual report on Form 10-K for the fiscal year ended March 31, 2004. We have experienced quarterly taxable income beginning with the second quarter of fiscal 2004. If we continue to produce taxable income in future periods, we may reverse a portion of our valuation allowance. This would generate income rather than expense from income taxes on our financial statements. We will continue to evaluate our ability to realize the deferred tax asset.

Liquidity and Capital Resources

We have historically financed our operations through a combination of debt and equity financing and cash generated from operations. Total cash, cash equivalents and short-term investments as of September 30, 2004 were $30.7 million compared to $20.3 million as of March 31, 2004. Receivables increased $3.6 million to $9.8 million as of September 30, 2004 compared to $6.1 million as of March 31, 2004. Receivables days sales outstanding were 52 and 35 days as of September 30, 2004 and March 31, 2004, respectively, with the increase due primarily to our having shipped a higher percentage of our revenues late in the three month period ended September 30, 2004 compared to the three month period ended March 31, 2004. We expect days sales outstanding to range from 45 to 50 days in the future, depending on the linearity of our shipments. Inventories increased by approximately $440,000 and inventory reserves decreased by approximately $610,000 due to scrapping and sales of previously reserved inventory. Net inventory increased by approximately $1.1 million, resulting in a net inventory balance of $7.6 million as of September 30, 2004 compared to $6.5 million as of March 31, 2004. The increase in net inventory was the result of increased production to support our expected growth in shipments. Accounts payable and other accrued liabilities decreased by $1.8 million during the six month period ending September 30, 2004 to a balance of $7.2 million, due to payment of accrued employee bonuses and the acceleration of payments to suppliers just prior to the October 2004 start-up of our new Oracle business system in order to ease our transition.

Operating activities used approximately $1.2 million of cash during the six month period ended September 30, 2004, compared to $1.2 million of positive cash flow from operations for the six month period ended September 30, 2003. The decrease was primarily due to a decrease in accounts payable and other current liabilities and an increase in accounts receivable, offset by a swing to net income from a net loss. Investing activities used $20.2 million of cash during the six month period ended September 30, 2004, which was the result of net purchases of $18.8 million of short-term investments and $1.4 million of capital expenditures.

Net cash provided by financing activities for the six month period ended September 30, 2004 was $12.8 million and was the result of $18.0 net proceeds from our public offering of common stock, $1.1 million of proceeds from the exercise of common stock warrants and $646,000 of proceeds from sales of stock in employee stock plans, offset by $7.1 million of repayment of long-term debt. The $7.1 million of debt repayment was comprised of approximately $400,000 of regularly scheduled debt payments and the early retirement of $6.6 million of debt to Silicon Valley Bank using proceeds from our May 2004 public stock offering.

The following table summarizes our contractual obligations as of September 30, 2004:

In the future, it is possible that our liquidity could be impacted in order to resolve an environmental issue arising out of the closure of our Milpitas wafer fabrication facility. As described in Note 15 of Notes to Condensed Financial Statements, we currently estimate that the cost to remediate the site will be approximately $50,000; however, the cost will ultimately depend on the nature and extent of contamination that is found during the cleanup and any risks posed by such contamination.

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In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter due to reduced customer requirements and to close our thin film manufacturing operation in Tempe, Arizona. As a result, we expect to use approximately $1.5 million of cash related to terminating employees and preparing the Tempe facility for sale. Of the $1.5 million, we expect to use approximately $600,000 during the three month period ended December 31, 2004, and $450,000 during the three month period ended March 31, 2005. After the sale of assets we expect the full exit and closure activity to be cash neutral or positive.

We currently anticipate that our existing cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for the next twelve months. However, we may need to raise additional funds through public or private equity or debt financing in order to expand our operations to the level we desire. The funds may not be available to us, or if available, we may not be able to obtain them on terms favorable to us.

RISK FACTORS AND OTHER FACTORS THAT COULD AFFECT FUTURE RESULTS

Our operating results may fluctuate significantly because of a number of factors, many of which are beyond our control and are difficult to predict. These fluctuations may cause our stock price to decline.

Our operating results may fluctuate significantly for a variety of reasons, including some of those described in the risk factors below, many of which are difficult to control or predict. While we believe that quarter to quarter and year to year comparisons of our revenue and operating results are not necessarily meaningful or accurate indicators of future performance, our stock price historically has been susceptible to large swings in response to short-term fluctuations in our operating results. Should our future operating results fall below our guidance or the expectations of securities analysts or investors, the likelihood of which is increased by the fluctuations in our operating results, the market price of our common stock may decline.

We incurred quarterly losses for ten consecutive quarters beginning with the quarter ended March 31, 2001 and ending with the quarter ended June 30, 2003, and we may be unable to sustain profitability.

Prior to achieving profitability in the second quarter of fiscal 2004, we had been unprofitable for ten consecutive quarters, incurring an average loss of $3.8 million per quarter and doubling our accumulated deficit from $31.3 million to $67.7 million. Many factors will affect our ability to sustain profitability including the health of the Mobile, Computing and Digital Consumer markets in which we focus, continued demand for our products by our key customers, lack of price erosion, availability of capacity from our manufacturing subcontractors, continued product innovation and design wins, and our continued ability to manage our operating expenses. In addition, our planned exit of the Medical business and closure of our Tempe facility (see Note 16 of Notes to Financial Statements) in the next six months will not only result in a material decrease in revenue starting in our fourth fiscal quarter of 2005 and beyond, as Medical has typically been between 15% and 20% of our revenues over the past several quarters with margins approximating our company gross margins, it will also lead to one-time expenses estimated between $2.2 million and $3.2 million, most of which will be incurred during the second half of fiscal 2005. Therefore, the likelihood of our incurring losses in the near term is significantly increased. The semiconductor industry has historically been cyclical, and we may be subject to such cyclicality, which could lead to our incurring losses again.

Our revenues could fall below cash breakeven causing us to cut our expenses which could result in our reducing our investment in research and development and marketing.

We have restructured our company to better focus our business and to transition to a fabless model by outsourcing our manufacturing, except for our thin film products. We have taken these steps in an effort to reduce the level of revenues we need to generate to achieve operating cash flow breakeven and at the same time to increase our revenues in key markets. However, if our net sales do not continue to satisfy our cash needs, then we may have to cut additional expenses in order to conserve our cash, or raise additional financing, of which there can be no assurance of success. Even if we are successful in reducing our cash usage, we may raise additional equity financing to finance growth, for strategic acquisitions, and/or to provide us with cash reserves should we operate at a loss in the future. We plan to discontinue our Medical thin film products in March 2005 (see Note 16 of Notes to Financial Statements). In the three months ended September 30, 2004 our Medical products revenue was $2.2 million. By the first quarter of fiscal 2006, we will no longer be generating revenue from Medical products. If we are unable to replace revenues from our Medical business with revenues from our core business, then we could operate at a loss and unless we believed that we would ultimately be able to increase our core business revenues, we may need to reduce expenses.

In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter and to close our thin film manufacturing operation in Tempe, Arizona. We could be unfavorably impacted if we are unable to sell the site or sell it for less substantially less than we have estimated.

We expect to incur $2.2 million to $3.2 million of costs related to terminating employees, selling or abandoning equipment and maintaining the Tempe facility until we sell it. If we are unable to sell the site or sell it for substantially less than we have estimated, we will incur higher closure costs than we have estimated, which would negatively impact our results and cash position, most likely during the remainder of fiscal 2005.

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We currently rely heavily upon a few customers for a large percentage of our net sales. Our revenue would suffer materially were we to lose any one of these customers.

Our sales strategy has been to focus on customers with large market shares in their respective markets. As a result, we have several large customers. During the quarter ended September 30, 2004, Motorola and LG Electronics, customers in the Mobile market, and Guidant, a customer in the Medical market, together represented approximately 45% of our net sales.

Guidant has determined that it will not require a sufficient level of products from us going forward for us to earn a reasonable margin on our sales of these products, and as a result, in October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter and close our Tempe thin film manufacturing operation. See Note 16 of Notes to Financial Statements. As described above, this could result in significantly decreased revenue unless and until the revenue from our core business grows enough to replace our Medical products revenue, of which there can be no assurance.

Also, in the quarter ended September 30, 2004, Motorola and LG Electronics together represented approximately 50% of our sales in the Mobile market. We may become increasingly dependent upon Motorola over the next twelve months as we believe that we have more penetration of their planned new products than their current products. There can be no assurance that Motorola and LG Electronics will continue to purchase our products in the quantities forecasted, or at all.

During the quarter ended September 30, 2004, one of our distributors, Epco Technology, represented 14% of our net sales. If we were to lose Epco as a distributor, we might not be able to obtain another distributor to represent us or a new distributor might not have the same relationships with the current end customers to maintain our current level of net sales. Additionally the time and resources involved with the changeover and training could have potentially adverse impacts on our business.

We currently rely heavily upon a few core markets for the bulk of our sales. If we are unable to further penetrate the Mobile, Computing and Digital Consumer markets, our revenues could stop growing and might decline.

Most of our revenues in recent periods have been derived from sales to manufacturers of Mobile, Computing and Digital Consumer, and Medical devices. We will discontinue our Medical devices in the March 2005 quarter due to our Medical customer no longer requiring enough product from us to make our Tempe operations economically viable. In order for us to be successful, we must continue to penetrate the Mobile, Computing and Digital Consumer markets, both by obtaining more business from our current customers and by obtaining new customers. Due to our narrow market focus, we are susceptible to materially lower revenues due to material adverse changes to one of these markets. For example, should the Mobile phone demand in China prove to be a bubble, or should growth not occur in the markets we have penetrated the most, our future revenues would be adversely impacted.

Our fastest growing market has been the Mobile market. A slowdown in the adoption of ASIPs by cellular handset manufacturers would reduce our future growth.

Much of our revenue growth over the past two years has been in the Mobile market where more complex cellular handsets have meant increased adoption of and demand for ASIP solutions. Should the rate of ASIP adoption decelerate in the Mobile market, our planned rate of increase in Mobile market penetration would decrease, thereby reducing our future growth.

The markets in which we participate are intensely competitive and our products are not sold pursuant to long-term contracts, enabling our customers to replace us with our larger competitors if they choose.

Our core markets are intensely competitive. Our ability to compete successfully in our core markets depends upon our being able to offer attractive high quality products to our customers that are properly priced and dependably supplied. Our customer relationships do not generally involve long-term binding commitments making it easier for customers to change suppliers and making us more vulnerable to competitors. Our customer relationships instead depend upon our past performance for the customer, their perception of our ability to meet their future need, including price and delivery and the timely development of new devices, the lead time to qualify a new supplier for a particular product, and interpersonal relationships and trust.

Because we operate in different semiconductor product markets, we generally encounter different competitors in our various market areas. Competitors with respect to our integrated passive products include ON Semiconductor, Philips

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Electronics, Semtech and STMicroelectronics. Our integrated passive products also compete with ceramic devices from competitors such as Murata, TDK and Innochips Technology, and discrete passives from competitors such as Murata, Samsung and Vishay. For our other semiconductor products, our competitors include Fairchild Semiconductor, Linear Technology, Maxim Integrated Products, Micrel, National Semiconductor, ON Semiconductor, RichTek, Semtech, STMicroelectronics and Texas Instruments. Many of our competitors are larger than we are, have substantially greater financial, technical, marketing, distribution and other resources than we do and have their own facilities for the production of semiconductor components.

Deficiencies in our internal controls could cause us to have material errors in our financial statements, which could cause us to have to restate them. Such a restatement could cause continued drain on our resources to address and correct internal control deficiencies and could have adverse consequences on our stock price, potentially limiting our access to financial markets.

We have in the past had deficiencies in certain of our internal control processes. We are vulnerable to difficulties as many of our recordkeeping processes are manual or involve software that has not been upgraded and for which we have no adequate backup if the software were to fail. We have also experienced in the past, high turnover in our finance department, due in part to the relocation of several functions from Tempe to Milpitas and the employees performing those functions being unwilling to relocate. While preparing our financial statements for the 2003 fiscal year, both our internal staff and prior outside accountants found errors in certain primary financial processes, which they corrected during such preparation. However, these errors caused inaccuracies in the fiscal 2003 interim results for the three, six and nine month periods that required these interim period results to be restated. As a result, our prior outside accountants informed us that they had noted a combination of reportable conditions that, taken together, constituted a material weakness in our internal controls. The material weakness included issues with our inventory costing systems and procedures, accounts payable cutoff, information systems user administration and finance organization. We have instituted additional processes and procedures to mitigate the conditions identified and to provide reasonable assurance that our internal control objectives are met. During fiscal 2004, we recruited an almost entirely new finance department and we have instituted backup procedures for our manual processes as we automate them, although some key controls remain manual and are consequently inefficient. We have devoted substantial effort and resources to improving our internal controls. We expect that the design and operation of our new Oracle business system will help us improve our internal control over our business and financial processes; however, there can be no assurance that we will nonetheless not have a material error in our financial statements.

In October 2004 we started to use new Oracle business system software. Should we encounter significant difficulties with the software or with our revised business processes, our or our independent accountants’ assessment of our internal control over financial reporting may indicate significant deficiencies or a material weakness in such internal control. Such assessments, if they were to occur, would appear in our Form 10-Q for the period ended December 31, 2004 or in our Form 10-K for the year ended March 31, 2005. Any such material weakness may need to be corrected before our outside accountants would be able to issue an audit report with an unqualified opinion.

In October 2004 we began live use of portions of our new enterprise resource planning (“ERP”) software, which has been a complex task to install, requiring large amounts of time and effort from our employees, consultants, and management. It is not uncommon for companies implementing ERP software to encounter delays and system start-up difficulties. As part of our implementation we have made significant changes to some of our business processes. We will be relying on our new ERP software to automate our inventory control and costing systems. Should we encounter difficulties with these or other features or with our revised business processes, we may not have time to fully test our ERP software prior to March 31, 2005. As a result, we would have to rely on manual checks and balances for inventory costing to avoid errors in our financial reporting of our year-end results, as we have done in the past. These checks and balances, while adequate in the past for such purposes, may lead us, or our outside accountants, to assess our internal control over financial reporting as having significant deficiencies. If we had other significant deficiencies as well, it is possible that we or our independent accountants assessing our internal control over financial reporting as part of our fiscal 2005 report on Form 10-K could determine that we have a material weakness in such control. Any such material weakness may need to be corrected before our outside accountants would be able to issue an audit report with an unqualified opinion.

While we believe we currently have adequate internal control over financial reporting, we are required to evaluate our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from such evaluation could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404), beginning with our Annual Report on Form 10-K for the fiscal year ending March 31, 2005, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our auditors have issued an attestation report on management’s assessment of such internal controls.

The Committee of Sponsoring Organizations of the Treadway Commission (COSO) provides a framework for us to assess and improve our internal control systems. Auditing Standard No. 2 provides the professional standards and related performance guidance for auditors to attest to, and report on, management’s assessment of the effectiveness of internal

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control over financial reporting under Section 404. Management’s assessment of internal controls over financial reporting requires management to make subjective judgments and, particularly because Section 404 and Auditing Standard No. 2 are newly effective, some of the judgments will be in areas that may be open to interpretation and therefore the report may be uniquely difficult to prepare and our auditors may not agree with our assessments.

While we currently believe our internal control over financial reporting is effective, we are still performing the system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if we identify one or more material weaknesses in our internal control over financial reporting, we may be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of March 31, 2005 (or if our auditors are unable to attest that our management’s report is fairly stated or they are unable to express an opinion on the effectiveness of our internal controls), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price.

While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with these new requirements and that we are currently implementing a new business information system. In this regard, if we are unable to provide our results and assessments to our auditors on a timely basis, our auditors may not have sufficient staff necessary to complete their work and issue their attestation report by the required date. If we are not able to complete our assessment in a timely manner, we and our auditors may be unable to conclude that our internal control over financial reporting is effective as of March 31, 2005.

Our competitors have in the past and may in the future reverse engineer our most successful products and become second sources for our customers, which could decrease our revenues and gross margins.

Our most successful products are not covered by patents and have in the past and may in the future be reverse engineered. Thus, our competitors can become second sources of these products for our customers or our customers’ competitors, which could decrease our unit sales or our ability to increase unit sales and also could lead to price competition. This price competition could result in lower prices for our products, which would also result in lower revenues and gross margins. Certain of our competitors have announced products that are essentially copies of some of our most successful products, especially in the Mobile market, where many of our largest revenue generating products have been second sourced. To the extent that the revenue secured by these competitors has exceeded the expansion in market size resulting from the availability of second sources, this has decreased the revenue potential for our products. Furthermore, should a second source attempt to increase its market share by dramatic or predatory price cuts for large revenue products, our revenues and margins could decline materially.

In the future our revenues will become increasingly subject to macroeconomic cycles and more likely to decline if there is an economic downturn.

As ASIP penetration increases, our revenues may become increasingly susceptible to macroeconomic cycles because our revenue growth may become more dependent on growth in the overall market rather than primarily on increased penetration, as has been the case in the past.

Our reliance on foreign customers could cause fluctuations in our operating results.

International sales for the past few years have accounted for approximately two-thirds of our total net sales. International sales include sales to U.S. based customers if the product is delivered outside the United States.

In October 2004, we decided to exit our thin film Medical device business during the March 2005 quarter, and we expect that sales of our thin film Medical devices will end in March 2005. Accordingly, we expect that a higher proportion of our sales will come from our international customers as we discontinue this business, which has been all U.S. based. See Note 16 of Notes to Financial Statements.

If international sales account for an increasing portion of our revenues, this would subject us to the following risks: